California Overhauls The Health Care Landscape

In a little-noticed regulatory earthquake that will have significant rippling effects on the health care industry, Governor Gavin Newsom signed Senate Bill 184 in June 2022, the California Health Care Quality and Affordability Act. The Act instructs the Office of Health Care Affordability (OHCA) to (i) investigate health care transactions that could have a cost or market competition impact, (ii) set and enforce sector-specific cost trend targets (with corrective plans and potentially large monetary penalties for health care entities exceeding OHCA's target cost trends), (iii) collect data from health plans and providers on health care expenditure and cost trends, and (iv) establish sector-specific best practices and support alternative payment models. California thus joins Massachusetts and Oregon, which have established regulatory oversight of health care costs.

OHCA Board and Cost Targets

OHCA will be guided by an appointed Health Care Affordability Board, with the authority to define regulated health care sectors, set sector-specific cost targets and fines for noncompliance, set benchmarks for primary care and behavioral health spending, and approve goals for the adoption of alternative payment models and standards. SB184 does not require industry or patient/consumer Board representation.

OHCA's initially regulated sectors include health plans, physicians, hospitals, ambulatory surgery centers, laboratories, and imaging centers, but the Board has the authority to broaden that scope. The cost targets will include a geographic cost adjustment factor, as well as a risk adjustment factor, much like we see today with Medicare Advantage's HCC-RAF scores. There also is an inherent tension in SB 184's efforts to stabilize or reduce health care costs, as the legislation and OHCA also is intended to promote workforce stability, but rising workforce costs (especially in the hospital sector) are driving higher health care costs.

What's the practical effect of these cost targets that will come into effect in 2025 and be enforced in 2026? The California healthcare industry will have a whole new process requiring it to submit data to OHCA, perform analyses and apply risk adjustment and other required formulas, respond to audits and inquiries, request exemptions or waivers and negotiate corrective action plans and penalties. This will literally be happening every year, requiring reporting health care entities to build this entire new function or to hire consultants. Compliance costs will be significant, even for California health care entities that meet the OHCA cost targets, and consultants will do very well under SB184. Health care entities that repeatedly do not meet OHCA cost targets may have liability up to the full amount by which they exceeded the cost target. Given the margins under which health care entities operate today, administrative fines (and the uncertainty of OHCA's enforcement) may result in material financial uncertainty.

New Hurdles for Mergers, Acquisitions and Possibly Joint Ventures

OHCA will be examining health care mergers, acquisitions, corporate affiliations and other transactions that entail material changes to ownership, operations, or governance of health care service plans, insurers, hospitals or hospital systems, physician organizations, providers, pharmacy benefit managers, and other health care entities. On or after April 1, 2024, a health care entity must provide OHCA with written notice at least 90 days prior to entering into the agreement or closing a transaction that would sell, transfer, lease, exchange, option, encumber, convey, or otherwise dispose of a material amount of assets, or that would transfer control, responsibility, or governance of a material amount of the assets or operations of the health care entity to one or more entities. Within 60 days of receipt of a notice of material change, OHCA will determine whether to conduct a cost and market impact review. That period can be extended upon OHCA's request. An agreement or transaction being reviewed by OHCA cannot be implemented until 60 days after OHCA issues a final report. This new OHCA process adds at least 4 months to any transaction timetable, and maybe materially longer due to interagency coordination or backlog.

The notice of material change requirements do not apply to: (1) exempted providers, unless the provider is being acquired by or affiliated with an entity that is not exempt; and (2) insurance company, health plan and non-profit hospital transactions that are reviewed by the Department of Managed Health Care (DMHC), Insurance Commissioner or California Attorney General (CAG). California's approach is similar to that of Massachusetts, where the Health Policy Commission reviews proposed actions based on criteria of cost and competition, but does not exceed the recently passed Oregon legislation, which authorizes the Oregon Health Authority to unilaterally approve, approve with conditions, or not approve the transaction upon review.

That being said, OHCA may flag concerning transactions to the CAG. Currently, both the CAG and DMHC routinely impose contractual undertakings as a requirement for regulated transactions to proceed. These undertakings may be long-term and, if used with OHCA transactions, may create an opportunity for the State to drive the direction of the health care industry.

This possibility of contractual undertakings raises the stakes for the upcoming OHCA implementing regulations and creates deal issues regarding certainty of closing and financial effects of the regulatory review. We expect much more lobbying, litigation and concern as the industry awakens to this new regulatory environment. We also expect many companies to re-think their views on the outlook for California's health care industry.